Study: Insider Trading Ruling Ineffective

A rule that lets executives sell shares in their companies according to a predetermined plan once looked like a way to stop businesspeople from trading on their access to inside information.

But it hasn't worked out that way, according to a new study.

Almost six years after the Securities and Exchange Commission established the rule, a Stanford University business school analysis of trading patterns has uncovered a statistical link between executive sales under the rule and negative corporate news.

On average, executives participating in the programs initiated 10.4 percent of their stock sales before a negative earnings report that would send share prices lower. Sales were initiated only 5.2 percent of the time in advance of positive earnings news.

If the sales pattern were truly random, one would expect those percentages to be about equal, Stanford business professor Alan D. Jagolinzer wrote in the report, which is undergoing peer review. The study examined stock sales at 191 companies from October 2001 to the end of 2003.

Jagolinzer didn't find any conclusive evidence to prove that executives were gaming the system. But he speculated that executives could be timing the release of corporate news that might have an effect on their stock sales, given that insiders know when their trades are scheduled to occur.

Jagolinzer said regulators should take a closer look at the rule, known as 10b5-1.

The SEC established the rule to encourage executives to set up predetermined plans for unloading shares of stock and options awarded to them as part of compensation packages. Trades planned in advance under a automatic trading program are protected from civil or criminal penalties.

The rule was used by former Enron chairman Kenneth L. Lay "to protect up to $100 million in personal stock sales prior to Enron's demise," Jagolinzer said.

Corporate governance experts have generally supported the plans. Patrick McGurn, executive vice president of Institutional Shareholder Services in Rockville, Md., said, "there is just less room for mischief" when the timing of stock sales is taken out of the hands of executives.

Keith Bishop, a former head of the California Department of Corporations, said there is rarely a good time for insiders to trade.

"But this rule is designed to ensure that insiders are not trading on the basis of nonpublic material information," he said.

When it comes to executive pay, the real money is often in the stock options, which is why the corporate leaders making some of the largest sums rely on the legal protections of 10b5-1 programs.

In a study of executive pay at California's largest companies, the top moneymakers from options in the last fiscal year were Terry Semel, chief executive of Yahoo, $173 million; Countrywide Financial CEO Angelo Mozilo, $119 million; Bruce Karatz, KB Home's chief executive, Carol Bartz, chief executive of Autodesk, $80 million and John Thompson, CEO of Symantec, $69 million.

Mozilo, Bartz and Thompson used 10b5-1 plans to manage their stock option trading. The Stanford study did not look at those trades, and there are no indications that the executives abused the rule. *